In economics we define inflation as ‘the increase in general price level of goods and services in an economy over a period of time’. An inflation affects the overall growth of an economy. All units of economy and especially business houses are affected by inflation. However, it is to be noted that not all inflation is bad. Economist believe that a certain percentage of inflation is necessary for boosting economic activity of investment and saving, production and consumption, exchange, etc. Business houses too benefit from it as it allows them to invest more, hire more workforce, built in infrastructure and overall improves their confidence. But it is equally true that if the rate of inflation is very high it can lead to severe loss to the business.
Now the question arises what is the cause of inflation in the economy. Economist have broadly categorized causes of inflation under two heads:-
a. Demand pull inflation
Demand-pull inflation is caused when aggregate demand in an economy exceeds aggregate supply. It is a situation where production rises and unemployment falls. This is commonly described as too much money chasing too few goods. Demand pull inflation explains how price inflation starts. Here a few causes of demand pull inflation:-
i) There is an increase in consumption and investment.
ii) There is a sudden increase in exports which might lead to a massive under-valuation of the currency.
iii) Government spending increases to a considerable extent.
iv) There is excessive monetary growth, there is too much of money in circulation against a few goods. The ‘price’ of a good will thus increase.
b. Cost push inflation
Cost-push inflation is caused by substantial increases in the cost of goods or services whose substitutes are not available. For example, the oil crisis of the 1970s. It is said that in this case inflation resulted from increases in the cost of petroleum imposed by the member states of OPEC. Since petroleum is very important to industrialized economies, a large increase in its price can lead to the increase in the price of most products, raising the price level and also the cost of production for various business units. Causes of this type of inflation are:-
i) Companies that have a monopoly over an industry create cost-push inflation.
ii) Natural disasters are another reason.
iii) Government tax and subsidy policy affects the cost of production and therefore changes in them can lead to inflation.
iv) Any country that allows the value of its currency to fall will experience higher import prices leading to inflationary trends.
We have so far discussed so much about what is inflation and how it is caused. Now we discuss that in actual what all positive or negative impact does it have on a business.
i. With an increase in price level the business houses too have to revise their prices for the product and services they provide (also known as menu cost). The business needs to recover its cost of production along with earning a minimal profit. But with constant fluctuation in prices they have to keep updating prices which causes chaos in normal operation of business.
ii. Also the employees of any business are also in general consumers. With rising inflationary trend their purchasing power gets reduced and as a result they ask for increase in their salary which is an additional burden on the business houses as they need to meet with these needs or else there will be strikes and lockouts.
iii. Cost of borrowing also gets affected by inflation. Inflation can be a good for borrowers. When a business borrows money, it gets cash which can be used at present and can be paid back later. Since inflation causes the value of currency to fall, cash now is worth more than cash in the future. In other words, inflation lets debtors pay lenders back with money that is worth less than it was when they originally borrowed it. Thus, when a business borrows under inflationary trends it is profitable for it and vice-versa.
iv. If one country has a much higher rate of inflation than others for a substantial period of time, this will make its exports less price competitive in world markets. In the end this may result in reduced export orders, lower profits and fewer jobs. This severely affects business houses involved in export dealings.
v. High and volatile rate of inflation is not good for business confidence partly because they cannot be sure of what their costs and prices are likely to be. This uncertainty might lead to a lower level of capital investment spending or because of speculation the chances of incurring losses becomes very high.
vi. Inflation does have positive impact on business like for initial stage the revenues earned are high, debt in this situation becomes a cheaper source of finance and overall the competitiveness and efficiency gets improved.
For smooth working of an economy certain rate of inflation is a must. Business usually faces cyclic situation of boom, depression and recession, theses may be for short or long period depending on the efficiency of fiscal and monetary tools which can control these situations. Since the element of uncertainty is attached with inflation business houses need to make predictions and assumptions which may be profitable or may lead to loss. It’s up to a company’s efficiency how it deals with inflationary situation and continue business in the long run